KrugmanMacro_SM_Ch13.

qxp 10/27/05 3:20 PM Page 155

macroeconomics
chapter
Money, Banking, and the Federal
Reserve System
1. For each of the following transactions, what is the effect (increase or decrease) on
13
M1? on M2?
a. You sell a few shares of stock and put the proceeds into your savings account.
b. You sell a few shares of stock and put the proceeds into your checking account.
c. You transfer money from your savings account to your checking account.
d. You discover $0.25 under the floor mat in your car and deposit it in your check-
ing account.

economics
e. You discover $0.25 under the floor mat in your car and deposit it in your savings

30
account.

Solution
1. a. Shares of stock are not a component of either M1 or M2, so holding fewer shares
does not decrease either M1 or M2. However, depositing the money into your sav-
ings account increases M2, since the savings account is part of M2 (but not part
of M1). M1 does not change.
b. Shares of stock are not a component of either M1 or M2, and so holding fewer
shares does not decrease either M1 or M2. However, depositing the money into
your checking account increases M1, since checking accounts are part of M1. It
also increases M2, since M1 is part of M2.
c. Moving money from savings to checking has no effect on M2, since both savings
accounts and checking accounts are included in M2. However, since savings
accounts are not part of M1, moving money from savings to checking does
increase M1.
d. Depositing cash into a checking account does not change M1 or M2. You are sim-
ply transferring money from one component of M1 (currency in circulation) to
another component of M1 (checkable deposits).
e. Depositing $0.25 into your savings account has no effect on M2, since both sav-
ings accounts and currency in circulation are in M2. However, since savings
accounts are not part of M1, depositing the $0.25 into your savings account
reduces M1.

2. There are three types of money: commodity money, commodity-backed money, and
fiat money. Which type of money is used in each of the following situations?
a. Mother-of-pearl seashells were used to pay for goods in ancient China.
b. Salt was used in many European countries as a medium of exchange.
c. For a brief time, Germany used paper money (the “Rye Mark”) that could be
redeemed for a certain amount of grain rye.
d. The town of Ithaca, New York, prints its own currency, the Ithaca HOURS, which
can be used to purchase local goods and services.

Solution
2. a. Mother-of-pearl is commodity money since the shells have other uses (for
instance, for shirt buttons).
b. Salt is commodity money since it has other uses.

155
156-157_KrugmanMacro_SM_Ch13.qxp 11/1/05 8:22 PM Page 156

156 MACROECONOMICS, CHAPTER 13

ECONOMICS, CHAPTER 30

c. The “Rye Mark” is commodity-backed money since its ultimate value is guaran-
teed by a promise that it can be converted into valuable goods (grain rye).
d. Ithaca HOURS are fiat money because their value derives entirely from their status
as a means of payment in Ithaca.

3. The table below shows the components of M1 and M2 in billions of dollars for the
month of December in the years 1995 to 2004 as published in the 2005 Economic
Report of the President. Complete the table by calculating M1, M2, currency in circu-
lation as a percentage of M1, and currency in circulation as a percentage of M2.
What trends or patterns about M1, M2, currency in circulation as a percentage of
M1, and currency in circulation as a percentage of M2 do you see? What might
account for these trends?

Currency Currency
Time in in
deposits circulation circulation
Currency Money smaller as a as a
in Traveler’s Checkable market than Savings percentage percentage
Year circulation checks deposits funds $100,000 deposits M1 M2 of M1 of M2
1995 $372.1 $9.1 $745.9 $448.8 $931.4 $1,134.0 ? ? ? ?
1996 394.1 8.8 676.5 517.4 946.8 1,273.1 ? ? ? ?
1997 424.6 8.5 639.5 592.2 967.9 1,399.1 ? ? ? ?
1998 459.9 8.5 627.7 732.7 951.5 1,603.6 ? ? ? ?
1999 517.7 8.6 597.7 832.5 954.0 1,738.2 ? ? ? ?
2000 531.6 8.3 548.1 924.2 1,044.2 1,876.2 ? ? ? ?
2001 582.0 8.0 589.3 987.2 972.8 2,308.9 ? ? ? ?
2002 627.4 7.8 582.0 915.5 892.1 2,769.5 ? ? ? ?
2003 663.9 7.7 621.8 801.1 809.4 3,158.5 ? ? ? ?
2004 699.3 7.6 656.2 714.7 814.0 3,505.9 ? ? ? ?

Solution
3. Here is the completed table:

Currency Currency
Time in in
deposits circulation circulation
Currency Checkable Money smaller as a as a
in Traveler’s bank market than Savings percentage percentage
Year circulation checks deposits funds $100,000 deposits M1 M2 of M1 of M2
1995 $372.1 $9.1 $745.9 $448.8 $931.4 $1,134.0 $1,127.1 $3,641.3 33.0% 10.2%
1996 394.1 8.8 676.5 517.4 946.8 1,273.1 1,079.4 3,816.7 36.5% 10.3%
1997 424.6 8.5 639.5 592.2 967.9 1,399.1 1,072.6 4,031.8 39.6% 10.5%
1998 459.9 8.5 627.7 732.7 951.5 1,603.6 1,096.1 4,383.9 42.0% 10.5%
1999 517.7 8.6 597.7 832.5 954.0 1,738.2 1,124.0 4,648.7 46.1% 11.1%
2000 531.6 8.3 548.1 924.2 1,044.2 1,876.2 1,088.0 4,932.6 48.9% 10.8%
2001 582.0 8.0 589.3 987.2 972.8 2,308.9 1,179.3 5,448.2 49.4% 10.7%
2002 627.4 7.8 582.0 915.5 892.1 2,769.5 1,217.2 5,794.3 51.5% 10.8%
2003 663.9 7.7 621.8 801.1 809.4 3,158.5 1,293.4 6,062.4 51.3% 11.0%
2004 699.3 7.6 656.2 714.7 814.0 3,505.9 1,363.1 6,397.7 51.3% 10.9%
156-157_KrugmanMacro_SM_Ch13.qxp 11/1/05 8:22 PM Page 157

M O N E Y, B A N K I N G , A N D T H E F E D E R A L R E S E R V E S Y S T E M 157

M1 consists of currency in circulation, traveler’s checks, and checkable deposits. M2

consists of M1 plus money funds, time deposits, and savings deposits. From 1995 to
2004, there is no obvious trend in M1. M1 grew by $236 billion (or 21% from 1995
to 2004) but was essentially stable from 1995 to 2001; all of this growth occurred
between 2002 and 2004. There is, however, a clear upward trend throughout the
period for M2, which grew by $2,756.4 billion (or 76% from 1995 to 2004).
Currency as a percentage of M1 grew from 33 percent to over 51 percent from 1995
to 2004, but currency as a percentage of M2 remained relatively constant, varying
from a low of 10.2% in 1995 to a high of 11.1% in 1999. The increase in currency as
a percentage of M1 could reflect increased use of credit cards, causing a reduction in
the importance of traveler’s checks and checkable deposits. Yet, since currency as a
percentage of M2 did not change, it could also reflect a shift from checkable deposits
to money funds, time deposits, and saving deposits.

4. Indicate whether each of the following is part of M1, M2, or neither:

a. $95 on your campus meal card
b. $0.55 in the change cup of your car
c. $1,663 in your savings account
d. $459 in your checking account
e. 100 shares of stock worth $4,000
f. A $1,000 line of credit on your Sears credit card

Solution
4. a. $95 on your campus meal card is similar to a gift certificate. Because it can only
be used for one purpose, it is not part of either M1, M2.
b. $0.55 in the change cup of your car is part of currency in circulation; it is part of
both M1 and M2.
c. $1,663 in your savings account isn’t directly usable as a medium of exchange, so
it is not part of M1; but because it can readily be converted into cash or checkable
deposits, it is part of M2.
d. A $459 balance in your checking account is part of M1 and M2; it represents a
checkable deposit.
e. 100 shares of stock are not part of either M1 or M2. Although an asset, stock is
not a highly liquid asset.
f. A $1,000 line of credit on your Sears credit card account is not part of either M1
or M2 because it does not represent an asset.

5. Tracy Williams deposits $500 that was in her sock drawer into a checking account at
the local bank.
a. How does the deposit initially change the T-account of the local bank? How does
it change the money supply?
b. If the bank maintains a reserve ratio of 10%, how will it respond to the new
deposit?
c. If every time the bank makes a loan, the loan results in a new checkable bank
deposit in a different bank equal to the amount of the loan, by how much could
the money supply in the economy expand in total?
d. If every time the bank makes a loan, the loan results in a new checkable bank
deposit in a different bank equal to the amount of the loan and the bank main-
tains a reserve ratio of 5%, by how much could the money supply expand in
response to an initial cash deposit of $500?
KrugmanMacro_SM_Ch13.qxp 10/27/05 3:20 PM Page 158

158 MACROECONOMICS, CHAPTER 13

ECONOMICS, CHAPTER 30

Solution
5. a. Initially, the bank’s reserves rise by $500, as do its checkable deposits. There is no
initial change in the money supply; currency in circulation has fallen by $500 but
checkable deposits have increased by $500.

Assets Liabilities
Reserves +$500 Checkable Deposits +$500

b. The bank will hold $50 as reserves against the new deposit and make additional
loans equal to $450.
c. The money supply can expand by $4,500. Checkable deposits rise by $5,000—the
initial $500 deposit of cash plus $4,500 in loans and deposits. Only $4,500
($500/0.1 − $500) represents additions to the money supply. (Remember that
$500 of the increase in deposits came at the expense of a reduction in currency in
circulation when Tracy deposited $500 in her bank account.)
d. The money supply can expand by $9,500. Checkable deposits rise by $10,000 but
because the first $500 was a deposit of cash, only $9,500 ($500/0.05 − $500)
represents additions to the money supply.

6. Ryan Cozzens withdraws $400 from his checking account at the local bank and keeps
it in his wallet.
a. How will the withdrawal change the T-account of the local bank and the money
supply?
b. If the bank maintains a reserve ratio of 10%, how will the bank respond to the
withdrawal?
c. If every time the bank decreases its loans, checkable bank deposits fall by the
amount of the loan, by how much could the money supply in the economy con-
tract in total?
d. If every time the bank decreases its loans, checkable bank deposits fall by the
amount of the loan and the bank maintains a reserve ratio of 20%, by how much
will the money supply contract in response to a withdrawal of $400?

Solution
6. a. Initially, the bank’s reserves fall by $400, as do its checkable deposits. There is no
initial change in the money supply; currency in circulation has risen by $400 but
checkable deposits have decreased by $400.

Assets Liabilities
Reserves −$400 Checkable Deposits −$400

b. Assuming that the bank has other checkable deposits, the bank will be holding
insufficient reserves. The bank was holding $40 of the $400 withdrawal as
required reserves for the $400 deposit; however, the remaining $360 was being
held as required reserves for other deposits. The bank will have to reduce its
deposits by $3,600 (−$400/0.1 + $400) to reduce its required reserves by $360
(10% of $3,600). It will have to reduce deposits by calling in some of its loans.
c. The money supply will contract by $3,600 (−$400/0.1 + $400). Checkable
deposits fall by $4,000, but only $3,600 represents a decrease in the money
supply.
d. The money supply can decrease by $1,600 (−$400/0.2 + $400). Checkable
deposits fall by $2,000, but only $1,600 represents a decrease in the money
supply.
KrugmanMacro_SM_Ch13.qxp 10/27/05 3:20 PM Page 159

M O N E Y, B A N K I N G , A N D T H E F E D E R A L R E S E R V E S Y S T E M 159

7. The government of Eastlandia uses measures of monetary aggregates similar to those

used by the United States, and the central bank of Eastlandia imposes a required reserve
ratio of 10%. Given the following information, answer the questions below.
Bank deposits at the central bank = $200 million
Currency held by public = $150 million
Currency in bank vaults = $100 million
Checkable bank deposits = $500 million
Traveler’s checks = $10 million
a. What is M1?
b. What is the monetary base?
c. Are the commercial banks holding excess reserves?
d. Can the commercial banks increase checkable bank deposits? If yes, by how much
can checkable bank deposits increase?

Solution
7. a. M1 equals the sum of currency held by the public ($150 million), checkable
deposits ($500 million), and traveler’s checks ($10 million) or $660.
b. The monetary base is the sum of currency held by the public ($150 million) and the
reserves of the commercial banks (currency in bank vaults ($100 million) and bank
deposits ($200 million) at the central bank). The monetary base is $450 million.
c. Required reserves are $50 million (10% of $500 million). Because total reserves
are $300 million, the commercial banks are holding $250 million ($300 million
− $50 million) in excess reserves.
d. Since the commercial banks are holding excess reserves, they can increase
deposits. With a required reserve ratio of 10%, reserves of $300 million can sup-
port a total of $3,000 million ($300/0.1) in deposits. Commercial banks can
increase deposits by an additional $2,500 million.

8. In Westlandia, the public holds 50% of M1 in the form of currency, and the required
reserve ratio is 20%. Estimate how much the money supply will increase in response to a
new cash deposit of $500 by completing the table below. (Hint: The first row shows that
the bank must hold $100 in minimum reserves—20% of the $500 deposit—against this
deposit, leaving $400 in excess reserves that can be loaned out. However, since the public
wants to hold 50% of the loan in currency, only $400 × 0.5 = $200 of the loan will be
deposited in round 2 from the loan granted in round 1.) How does your answer compare
to an economy in which the total amount of the loan is deposited in the banking system
and the public doesn’t hold any of the loan in currency? What does this imply about the
relationship between the public’s desire for currency and the money multiplier?

Required Excess Held as

Round Deposits reserves reserves Loans currency
1 $500.00 $100.00 $400.00 $400.00 $200.00
2 200.00 ? ? ? ?
3 ? ? ? ? ?
4 ? ? ? ? ?
5 ? ? ? ? ?
6 ? ? ? ? ?
7 ? ? ? ? ?
8 ? ? ? ? ?
9 ? ? ? ? ?
10 ? ? ? ? ?
Total after
10 rounds ? ? ? ? ?
KrugmanMacro_SM_Ch13.qxp 10/27/05 3:20 PM Page 160

160 MACROECONOMICS, CHAPTER 13

ECONOMICS, CHAPTER 30

Solution
8. Here is the completed table:

Required Excess Held as

Round Deposits reserves reserves Loans currency
1 $500.00 $100.00 $400.00 $400.00 $200.00
2 200.00 40.00 160.00 160.00 80.00
3 80.00 16.00 64.00 64.00 32.00
4 32.00 6.40 25.60 25.60 12.80
5 12.80 2.56 10.24 10.24 5.12
6 5.12 1.02 4.10 4.10 2.05
7 2.05 0.41 1.64 1.64 0.82
8 0.82 0.16 0.66 0.66 0.33
9 0.33 0.07 0.26 0.26 0.13
10 0.13 0.03 0.10 0.10 0.05
Total after
10 rounds $833.25 $166.65 $666.60 $666.60 $333.30

After 10 rounds, loans can expand by $666.60; this is also the increase in the money
supply at this point. (Although deposits increase by $833.25, currency held by the
public falls by $166.70—it initially fell by $500 and eventually rose again by
$333.30.) If the total amount of each loan is deposited in the banking system (that
is, the public does not hold any of the loans in currency), the money supply would
increase by $2,000 (500/0.2 − $500); deposits would increase by $2,500. The
money multiplier decreases in size as the public holds a greater percentage of loans
in currency.

9. What will happen to the money supply under the following circumstances?
a. The required reserve ratio is 25%, and a depositor withdraws $700 from his check-
able bank deposit.
b. The required reserve ratio is 5%, and a depositor withdraws $700 from his check-
able bank deposit.
c. The required reserve ratio is 20%, and a customer deposits $750 to her checkable
bank deposit.
d. The required reserve ratio is 10%, and a customer deposits $600 to her checkable
bank deposit.

Solution
9. a. Deposits contract by $2,800 but $700 is converted into currency held by the pub-
lic. The money supply contracts by $2,100.
b. Deposits contract by $14,000 but $700 is converted into currency held by the
public. The money supply contracts by $13,300.
c. Deposits expand by $3,750 but currency in circulation falls by $750. The money
supply expands by $3,000.
d. Deposits expand by $6,000 but currency in circulation falls by $600. The money
supply expands by $5,400.
KrugmanMacro_SM_Ch13.qxp 11/15/05 3:25 PM Page 161

M O N E Y, B A N K I N G , A N D T H E F E D E R A L R E S E R V E S Y S T E M 161

10. Although the U.S. Federal Reserve doesn’t use changes in reserve requirements to
manage the money supply, the central bank of Albernia does. The commercial banks
of Albernia have $100 million in reserves and $1,000 million in checkable deposits;
the initial required reserve ratio is 10%. The commercial banks follow a policy of
holding no excess reserves. The public holds a fixed amount of currency, so all loans
create an equal amount of deposits in the banking system.
a. How will the money supply change if the required reserve ratio falls to 5%?
b. How will the money supply change if the minimum reserve ratio rises to 25%?

Solution
10. a. If the required reserve ratio falls to 5%, the commercial banks of Albernia will be
holding $50 million in excess reserves. Since the banks follow a policy of holding
no excess reserves, the banks will expand deposits by making loans. The banks’
reserves of $100 million will support $2,000 million in deposits at a reserve ratio
of 5%. The bank will expand loans and deposits by $1,000 million; so the money
supply expands by $1,000 million.
b. If the required reserve ratio rises to 25%, the commercial banks of Albernia will
not be holding enough reserves to support $1,000 million in deposits. The banks’
reserves will only support $400 million in deposits. The commercial banks will
have to decrease loans and deposits by $600 million; so the money supply will
contract by $600 million.

11. Using Figure 13-5, find the Federal Reserve district in which you live. Go to
http://www.federalreserve.gov/bios/pres.htm and identify the president of that Federal
Reserve Bank. Go to http://www.federalreserve.gov/fomc/and determine if the president
of the Fed is currently a voting member of the Federal Open Market Committee
(FOMC).

Solution
11. Answers will vary depending on where you live and when you look up your answer. If
you live in Reedley, California, in July 2005, you were in the San Francisco district of
the Federal Reserve system. Janet Yellen was the president of the Federal Reserve
Bank of San Francisco and an alternate (nonvoting) member of the FOMC at that
time.

12. Show the changes to the T-accounts for the Federal Reserve and for commercial banks
when the Federal Reserve buys $50 million in U.S. Treasury bills. If the public holds a
fixed amount of currency (so that all loans create an equal amount of deposits in the
banking system), the minimum reserve ratio is 10%, and banks hold no excess
reserves, by how much will deposits in the commercial banks change? By how much
will the money supply change? Show the final changes to the T-account for commercial
banks when the money supply changes by this amount.

Solution
12. When the Federal Reserve buys $50 million in Treasury bills from commercial banks,
its assets increase by $50 million (it now owns $50 million in Treasury bills) but its
liabilities also increase by $50 million as it credits the banks’ account at the Federal
Reserve, part of the monetary base. From the perspective of commercial banks, their
assets fall by $50 million because they sell Treasury bills to the Fed but their assets
also rise by $50 million when their deposits at the Fed (reserves) are credited with
$50 million.
KrugmanMacro_SM_Ch13.qxp 10/27/05 3:20 PM Page 162

162 MACROECONOMICS, CHAPTER 13

ECONOMICS, CHAPTER 30

Initial changes to the T-account of the Federal Reserve immediately after Fed pur-
chase of $50 million in Treasury bills:

Assets Liabilities
Treasury bills +$50 million Monetary base +$50 million

Initial changes to the T-account of commercial banks immediately after Fed purchase
of $50 million in Treasury bills:

Assets Liabilities
Treasury bills −$50 million
Reserves +$50 million

After the Federal Reserve buys $50 million from commercial banks, the banks are
holding $50 million in excess reserves. Since the banks do not want to hold any
excess reserves, they will increase loans and deposits by $500 million, the maximum
amount that $50 million in reserves can support. Therefore, the money supply will
also increase by $500 million.
All changes to the T-account of commercial banks after the Fed purchase of $50 mil-
lion in Treasury bills:

Assets Liabilities
Treasury bills −$50 million Checkable deposits +$500 million
Reserves +$50 million
Loans +$500 million

13. Show the changes to the T-accounts for the Federal Reserve and for commercial
banks when the Federal Reserve sells $30 million in U.S. Treasury bills. If the public
holds a fixed amount of currency (so that all new loans create an equal amount of
checkable bank deposits in the banking system) and the minimum reserve ratio is
5%, by how much will checkable bank deposits in the commercial banks change? By
how much will the money supply change? Show the final changes to the T-account
for the commercial banks when the money supply changes by this amount.

Solution
13. When the Federal Reserve sells $30 million in Treasury bills to commercial banks, its
assets decrease by $30 million (it now owns $30 million less in Treasury bills) but its
liabilities also decrease by $30 million as the banks pay the Federal Reserve for the
Treasury bills from their accounts at the Fed (part of the monetary base). From the
perspective of commercial banks, their assets rise by $30 million because they buy
the Treasury bills from the Fed but their assets also fall by $30 million when they pay
for the Treasury bills from their deposits at the Fed (their reserves).
Initial changes to the T-account of the Federal Reserve immediately after Fed sale of
$30 million in Treasury bills:

Assets Liabilities
Treasury bills −$30 million Monetary base −$30 million

Initial changes to the T-account of commercial banks immediately after Fed sale of
$30 million in Treasury bills:

Assets Liabilities
Treasury bills +$30 million
Reserves −$30 million
KrugmanMacro_SM_Ch13.qxp 10/27/05 3:20 PM Page 163

M O N E Y, B A N K I N G , A N D T H E F E D E R A L R E S E R V E S Y S T E M 163

After the Federal Reserve sells $30 million in Treasury bills, the banks are no longer
holding enough reserves to support their deposits. The banks will need to reduce
loans and deposits by $600 million—the amount of deposits that were supported by
the $30 million in reserves used to buy the Treasury bills. So the money supply will
also decrease by $600 million.
All changes to the T-account of commercial banks after Fed sale of $30 million in
Treasury bills:

Assets Liabilities
Treasury bills +$30 million Checkable deposits −$600 million
Reserves −$30 million
Loans −$600 million
KrugmanMacro_SM_Ch13.qxp 10/27/05 3:20 PM Page 164